R14 Risk Management for Individuals Flashcards
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Human Capital, Financial Capital, Economic Balance Sheet
- Human Capital - An implied asset; the net present value of an investor’s future expected labor income weighted by the probability of surviving to each future age. Also called net employment capital.
- Financial Capital - The tangible and intangible assets (excluding human capital) owned by an individual or household.
- Economic Balance Sheet - A balance sheet that provides an individual’s total wealth portfolio, supplementing traditional balance sheet assets with human capital and pension wealth, and expanding liabilities to include consumption and bequest goals. Also known as holistic balance sheet.
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Comparing Financial and Human Capital
Human capital is commonly defined as the mortality-weighted net present value of an individual’s future expected labor income. Financial capital includes the tangible and intangible assets (outside of human capital) owned by an individual or household.
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Net Wealth
The difference between an individual’s assets and liabilities; extends traditional financial assets and liabilities to include human capital and future consumption needs.
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4 Key Steps in Risk Management Process
- Specify the objective.
- Identify risks.
- Evaluate risks and select appropriate methods to manage the risks.
- Monitor outcomes and risk exposures and make appropriate adjustments in methods.
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4 Risk Techniques
- Risk Avoidance
- Risk Reduction
- Risk Transfer
- Risk Retention
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Financial Stages of Life
- Education phase - could benefit from products, such as life insurance, that hedge against the risk of losing human capital.
- Early career - Human capital represents such a large proportion of total wealth.Use of life insurance. 18 - 30’s.
- Career development - 35–50 age range. Retirement saving tends to increase.
- Peak accumulation - ages of 51–60. Emphasize income production for retirement and become increasingly concerned about minimizing taxes, given higher levels of wealth and income
- Pre-retirement - typically represents an individual’s maximum career income. May consider investments that are less volatile. There is further emphasis on tax planning
- Early retirement - 10 years of retirement. use resources to produce activities that provide enjoyment. Some retirees seek a new career. Need for asset growth does not disappear
- Late retirement - unpredictable because the exact length of retirement is unknown. Longevity risk. Cognitive decline can present a risk of financial mistakes, which may be hedged through the participation of a trusted financial adviser or through the use of annuities.
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Traditional vs. Economic Balance Sheet
A traditional balance sheet includes assets and liabilities that are generally relatively easy to quantify. An economic balance sheet provides a useful overview of one’s total wealth portfolio by supplementing traditional balance sheet assets with human capital and pension wealth and including additional liabilities, such as consumption and bequest goals.
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Changes in Human and Financial Capital
The total value of human capital and the total value of financial capital tend to be inversely related over time as individuals attempt to smooth consumption through borrowing, saving, and eventual spending. When human capital becomes depleted, without financial capital, an individual will have no wealth to fund his or her lifestyle. Human capital is generally largest for a younger individual, whereas financial capital is generally largest when an individual first retires.
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6 Individual Risk Exposures
- Earnings risk - The risk associated with the earning potential of an individual. Loss or reduction of earnings and may also include the loss of employer contributions to one’s retirement fund. The loss of income represents a reduction in both human and financial capital.
- Premature Death Risk - The risk of an individual dying earlier than anticipated; sometimes referred to as mortality risk. Effecton human and financial capital. Death expenses (including funeral and burial), transition expenses, estate settlement expenses, and the possible need for training or education for the surviving spouse may be needed
- Longevity risk - Financial planners often run a Monte Carlo simulation. Insufficient assets may exacerbate the situation and many pension programs do not consider inflation. Individual may choose to work longer.
- Liability Risk - individual or household may be held legally liable for the financial costs associated with property damage or physical injury. May affect the individual’s financial and/or human capital.
- Health Risk - risks and implications associated with illness or injury. Significant implications for human capital as well as for financial capital. An added risk is that inflation in long-term care costs (i.e., medical costs) has historically been higher than base inflation.
- Property Risk - a person’s property may be damaged, destroyed, stolen, or lost. Direct loss refers to the monetary value of the loss associated with the property itself. Indirect loss are expenses incurred asa resultof direct loss. Because property represents a financial asset, property risk is normally considered to be associated with a potential loss of financial capital. But property used in a business to create income is rightfully considered in a discussion of human capital.
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Types of Life Insurance
- Temporary life insurance - A type of life insurance that covers a certain period of time, specified at purchase. Commonly referred to as “term” life insurance. The cost of term insurance is less than that of permanent insurance, and the cost per year is less for shorter insured period
- Permanent life insurance - A type of life insurance that provides lifetime coverage. Policy premiums for permanent life insurance are usually fixed.
- Whole life insurance - in force for an insured’s entire life, requires regular, ongoing fixed premiums. Cash value associated with a whole life insurance policy that may be accessed if the insured chooses to do so. Can be participating (in profits) or non-participating (fixed rate).
- Universal life insurance - more flexibility than whole life insurance. Ability to pay higher or lower premium payments and often has more options for investing the cash value.
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Insurable interest for life insurance.
An insurable interest means that the policy owner must derive some type of benefit from the continued survival of the insured that would be negatively affected should the insured pass away. For example, an individual may rely on a spouse for his or her financial well-being.
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Life Insurance Pricing
- Mortality Expectations - estimate mortality based on both historical data and future mortality expectations. Actuaries typically make adjustments to consider additional factors e.g. health history,excess weight, risky activities. May require physical exam. All to avoid adverse selection - individuals who know that they have higher-than-average risk are more likely to apply for life insurance.
- Net Premium - represents the discounted value of the future death benefit. Must also consider the fact that the individuals who die within the five-year period will not be paying premiums for the remaining outstanding term. Some consumers buy an annually renewable term policy with the intention of taking advantage of the “loss-leader” pricing in the early years and then, when rates rise too much, switching to another company that has a lower premium at the newly attained age
- Gross Premium - adds a load to the net premium, allowing for expenses and a projected profit for the insurance company. Expenses are incurred by the insurer for both writing a life insurance policy and managing it on an ongoing basis. Premiums for level term policies are higher than those for annually renewable (one-year) policies in the early years. But premiums are lower in the later years of the policies—most notably for longer periods, such as a 20-year level term—because annually renewable term policies often have rapidly increasing premiums.
- Life insurers - stock companies and mutual companies. The former has a profit motive.
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3 most relevant elements of life insurance pricing.
- Mortality expectations: The insurer is concerned about the probability that the insured will die within the term of the policy. Actuaries evaluate mortality expectations based on historical experience, considering such factors as age and gender, the longevity of parents, blood pressure, cholesterol, whether the insured is a smoker, and whether the insured has had any diseases or injuries that are likely to lead to death during the policy term.
- Discount rate: A discount rate, or interest factor, representing an assumption of the insurance company’s return on its portfolio, is applied to the expected outflow.
- Loading: After calculating the net premium for a policy, which may be considered the pure price of the insurance, the insurance company adjusts the premium upward to allow for expenses and profit. This adjustment is the load, and the process is called loading
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Comparisons of Life Insurance Costs
Net Payment Cost Index
Assumes that the insured person will die at the end of a specified period, such as 20 years.
- Calculate the future value of an annuity due of an amount equal to the premium, compounded at a 5% discount rate for 20 years. An annuity due—an annuity for which the premium payment is received at the beginning of the period (versus an ordinary annuity, for which the premium payment is received at the end of the period)—is used because premiums are paid at the beginning of the period.
- Calculate the future value of an ordinary annuity of an amount equal to the projected annual dividend (if any), compounded at 5% for 20 years. An ordinary annuity is used because dividend payments are made at the end of the period.
- Subtract B from A to get the 20-year insurance cost.
- Calculate the payments for a 20-year annuity due with a future value equal to C and a discount rate of 5%. This amount is the interest-adjusted cost per year. Again, an annuity due is used because premium payments occur at the beginning of the year.
- Divide by the number of thousand dollars of face value.
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Comparisons of Life Insurance Costs
Surrender Cost Index
Assumes that the policy will be surrendered at the end of the period and that the policy owner will receive the projected cash value.
- Calculate the future value of an annuity due of an amount equal to the premium, compounded at 5% for 20 years. We use an annuity due here for the same reason indicated for the net payment cost index.
- Calculate the future value of an ordinary annuity of an amount equal to the projected annual dividend (if any), compounded at 5% for 20 years. We use an ordinary annuity here for the same reason indicated for the net payment cost index.
- Subtract B and the Year 20 projected cash value from A to get the 20-year insurance cost.
- Calculate the payments for a 20-year annuity due with a future value equal to C and a discount rate of 5%. This amount is the interest-adjusted cost per year.
- Divide by the number of thousand dollars of face value.
